Top 5 Answers About 1031 Exchange Rules in 2018

Monday, May 28, 2018
To the relief of many real estate investors, the recent tax reform left the 1031 exchange rules of IRS tax code Section 1031 essentially untouched. The tax reform did however limit the 1031 exchange rules to real estate, allowing you to still implement the benefits of a 1031 exchange as a real estate investor. Before we get started, let's review some basic 1031 exchange rules concepts:

Real Estate 1031 Exchange Rules: 
Important Concepts

Here are some important definitions that come into play in understanding 1031 exchange rules:
  1. 1.  Like-Kind Property
    Good news! All real estate is considered like-kind to all other real estate. That means you can exchange a building for land, a house for an apartment, etc. This gives a great deal of flexibility.
  2. 2.  Greater or Equal Value
    If you are hoping to defer 100% of your tax liability from the sale of your property, the 1031 exchange rules require that the net market value and equity of the replacement property be equal to or greater than the property you have sold. If it is not, then you may still have some immediate tax obligations on a portion of your sale price.
  3. 3.  Same Tax Payer
    The name on the title of the property sold must match the name of the title holder on the newly purchased property. The only exception to this is with a single member limited liability company. If there is only one member of a limited liability company, that individual can purchase the new property under their own individual name, even if the property that was sold was owned by the single member limited liability company.
  4. 4.  45-Day Identification Window
    After the closing has been completed on the sale of your first property, you will only have 45 calendar days to identify the property you intend to purchase of like-kind. This is sometimes difficult depending on the market. If you cannot find qualifiable property, you can take advantage of the 200% rule. With the 200% rule, you can identify more than three properties to purchase, but you must maintain a total property value of less than 200% of the value of the property you sold.
  5. 5. 180-Day Purchase Window
    You must have the purchase of your replacement property complete and closed within 180 days after the sale of your exchanged property in order to qualify for and meet the 1031 exchange rules. You must also have the purchase and closing completed prior to the due date of your income tax return, including extensions, for the year in which your property was sold.
  6. 6.  Investment or Business Property Only
    You cannot use a 1031 exchange for personal property. It is only valid when used for investment or business property. So, if you were hoping to swap your home in the country for a modern city loft, you will have to find another way to make that move. The easiest way to understand this is that you simply cannot exchange a primary residence for another.
  7. 7.  What is “boot?”
    If you purchase a property that is worth less than the property you sold, the difference between the two, known as “boot,” may be taxable. You can still qualify for a 1031 exchange, but at the time of sale you will have to pay capital gains taxes. Most investors are surprised that they are responsible for paying 25% tax on recaptured depreciation.

Now that we know some terminology:
What is a 1031 Exchange?

The 1031 Exchange Rules of IRS tax code Section 1031 define specifically what qualifies as a 1031 Exchange, or “Starker Exchange” as they are commonly referred to. Simply put, as an investor, you can “defer” some or all of the capital gains taxes when you sell an investment property. Of course, there are some requirements that must be met if you are going to qualify for the deferment. The primary requirement is that the profits from the sale of the investment property must be applied to the purchase of another “like-kind” property. There are other benefits other than deferring your tax liability as well. For example, if you have invested in low-income property that is high maintenance, you can easily reduce your tax liability with a 1031 exchange and move your focus into a low-maintenance investment.

Now, in the history of the 1031 Exchange it was typical for one property to literally be exchanged for another property of like-kind. Now, because it is very unlikely that the owner of the property you want to purchase, also wants to purchase your property, it is common to have a delayed exchange. The 1031 exchange rules allow you to use a middleman to “escrow” your funds from the sale of your first property, and then use the funds to make the purchase of your replacement property. Even though this is considered a three-party exchange, it is treated just as the more traditional, literal swap.

When should you consider a 1031 Exchange?

Taking advantage of the benefits of a 1031 exchange requires some specific criteria to be met. First, you must be selling an investment property. Even when you are a secondary investor and did not initially purchase the investment real estate yourself, you will be liable for the capital gains taxes upon the sale of the property. This is a great opportunity to use the 1031 Exchange Rules to your advantage. Sometimes we make bad investments or hit a run of bad luck, and when this happens, it can be expensive and even cause a loss. The 1031 Exchange will not likely be of much help in these situations. However, if you have a rental property which has increased in value since it was acquired, the 1031 Exchange can save you a great deal, leaving you plenty of opportunity to maximize the use of profits for your next investment. You are probably thinking, “that sounds great, but how do I do a 1031 Exchange? Well, that is exactly the next frequently asked 1031 Exchange Rules question we are going to cover, so stay with me here!

How can you do a 1031 Exchange today?

If you are looking to avoid capital gains, or at least defer them for a little while, the most effective way to complete a successful 1031 exchange is to replace the first investment property with a new property of similar value. When you do end up selling the new property it will be time to pay up on the capital gains taxes. However, you can use the 1031 exchange rules to aid you in preventing large and immediate tax liabilities.

One key requirement of the 1031 exchange rules is that both the purchase price must be equal to or greater that of the original property. For example, if you are selling a property for $2 million, you need to buy a property for $2 million or more to fully defer your capital gains taxes. Is it possible to purchase for less? Yes. This is called a partial exchange—and it is important that you carefully calculate your tax liability if you are not replacing the full value.

What are the basic types of 1031 Exchanges of Real Estate?

There are a variety of options available to investors who are interested in the benefits of a 1031 exchange with real estate. Depending on your specific circumstances, the 1031 exchange rules allow for a variety of situations to qualify as a 1031 exchange. The four most common like-kind exchange types are the simultaneous exchange, delayed exchange, reverse exchange and the construction/improvement exchange. Let’s take a closer look at each one and how they may be the right fit for your next investment move.
The simultaneous exchange, as the name suggests, takes place when the original property and the replacement property close simultaneously, or on the same day. This can occur in one of three basic ways.
1.  A two-party trade is completed when both property owners exchange or “swap” deeds.
2.  A three-party trade is completed by means of an “accommodating party” that is used to facilitate the exchange.
3.  Simultaneous exchange with a qualified intermediary who facilitates your exchange.
The most common type of 1031 exchange available to investors today is referred to as a delayed exchange. If you select to go this route, you will first complete the sale and purchase agreement for your initial investment property with your buyer. Then you must hire a third-party Exchange Intermediary who will complete the sale of your initial property. The funds from the sale will be held in a trust by the Exchange Intermediary while you secure a purchase agreement for the replacement property within 45 days. The new purchase must close within 180 days of the closing on your initial sale. This is another great benefit to selecting a delayed exchange, an extended timeframe in which to close your new purchase.

The third type of exchange investors can use is a reverse exchange. Because a reverse exchange requires all cash, they are more complicated to arrange. You will first acquire a replacement property through what is known as an exchange accommodation titleholder prior to identifying the replacement property. Essentially you will be buying first and paying later. It is very common for banks not to offer loans for these types of exchanges. You will also have to decide which investment properties you will acquire, and which ones will be “parked.” If you cannot properly close on the relinquished property within the required 180-day period that the acquired property is parked, you will forfeit the exchange completely. Some key differences in a reverse exchange from a delayed exchange are include:
1.  You must identify the property to be sold (the relinquished property) within 45 of your purchase.
2.  You must sell the relinquished property and purchase the replacement property within 180 days of the acquisition of the replacement property.

The fourth most common exchange type allowed by the 1031 exchange rules is known as a construction/improvement exchange. This type of exchange will allow you to improve the replacement property using the equity from your exchange. Please note the following additional requirements to allow you to defer the capital gains from this type of exchange.
1.  You must spend the entire exchange equity on completed improvements or as a down payment no later than the 180th day.
2.  You will also have to be purchasing “substantially the same property” that you identified by the 45th day.
3.  The replacement property must be valued at the same amount or more when it is deeded back to you. Also, the improvements must be complete and in place prior to you taking title back from the qualified intermediary.
 

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